US Supreme Court clarifies bankruptcy discharge standard

Listen to this article

The U.S. Supreme Court has clarified that proof of malicious intent is not required to prevent the bankruptcy discharge of a debt that arose from a trustee’s self-dealing.

“Where actual knowledge of wrongdoing is lacking, we consider conduct as equivalent if the fiduciary ‘consciously disregards’ (or is willfully blind to) ‘a substantial and unjustifiable risk’ that his conduct will turn out to violate a fiduciary duty,” wrote Justice Stephen G. Breyer in Bullock v. BankChampaign.

The court’s unanimous decision addressed the meaning of “defalcation” in §523(a)(4) of the Bankruptcy Code. Section 523(a)(4) pro­vides that an individual cannot obtain a bankruptcy dis­charge from a debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.”

The debtor in the case, Randy Curtis Bullock, became the trustee of a trust established by his father in 1978. The father created the trust for the benefit of Bullock and his four siblings.

Between 1981 and 1990, Bullock made three loans from the trust. Bullock made the first loan to his mother at his father’s request. The mother used the money to pay off a debt owed by the father’s business. The two other loans were to himself and his mother. The money from those loans was used to buy a steel mill and real estate. The three loans totaled about $204,000. All loans were repaid with interest.

Nonetheless, two of his brothers sued Bullock in Illinois state court when they learned of the loans, alleging that Bullock had breached his fiduciary duties as trustee. The state court, although finding that Bullock had not acted with a malicious motive, concluded that he had breached his fiduciary duties by engaging in self-dealing. In conjunction with finding Bullock liable, the state court appointed BankChampaign as trustee of the father’s trust.

Unable to pay the $250,000 judgment, Bullock filed for bankruptcy. BankChampaign filed an adversary proceeding, arguing that that the state court judgment was not dischargeable under §523(a)(4). Bullock argued that his actions did not amount to defalcation because he committed no intentional wrongdoing when withdrawing the money from the trust.

The case raised an issue that had divided the U.S. Circuit Courts of Appeals. The 5th, 6th and 7th Circuits had held that defalcation merely requires a showing of objectively reckless conduct. The 1st and 2nd Circuits had required a showing of extreme recklessness, while the 4th, 8th and 9th Circuits had held that even innocent trustee failures amount to defalcation.

In this case, the 11th Circuit applied an “objective recklessness” standard in upholding the bankruptcy court’s decision that the state court judgment against Bullock was nondischargeable.

In identifying the appropriate standard, Breyer concluded that the statutory term “defalcation” should be treated the same as the term “fraud” has historically been treated under the Bankruptcy Code.

“Thus, where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, the term requires an intentional wrong,” Breyer wrote. “We include as intentional not only conduct that the fiduciary knows is improper but also reckless conduct of the kind that the criminal law often treats as the equivalent.”

The court remanded the case to the 11th Circuit to decide whether Bullock was entitled to a discharge under this heightened standard.